The Federal Reserve ("the Fed") was founded in 1914
after four severe banking panics. The Fed is largely independent
of the authority of the Congress and President.

The role of the Fed is to conduct stabilization policy and to
act as a lender of the last resort to banks in order to prevent
financial disasters like those that occurred during the Great
Depression.

The Board of Governors is the highest governing body
of the Federal Reserve. It consists of 7 members including the
chairperson, currently Ben Bernanke.

The Twelve District Banks perform numerous functions
in their Districts. They regulate and supervise banks, run a
check-clearing service, do research and monitor the economic
activity in their areas, circulate the currency in their
districts, sell savings bonds, and so on.

The F.O.M.C. (Federal Open Market Committee) is responsible
for directing monetary policy. The committee is made up of 12
members, 7 from the board of governors plus 5 Presidents of the
District Banks who serve on a rotating basis.

There are three "tools" that the Fed can use to
conduct monetary policy. They are Open Market Operations (OMO), a
change in the discount rate, and a change in the reserve
requirement ratio.

An Open Market Operation is the purchase or sale of
government securities via transactions in the open market. An
open market purchase injects excess reserves into the banking
system, and leads to an expansion of the money supply. An open
market sale, on the other hand, removes reserves from the system
and reduces the money supply.

The discount rate is the interest rate at which the
Federal Reserve lends funds to banks. If the Fed lowers the
discount rate, it is signaling to banks that it is easing up the
money supply.

If the Fed lowers the reserve requirement ratio (RRR), then
it is allowing banks to lend out funds that they previously had
to hold as reserves. Therefore, a lowering of this ratio is
expansionary.

Expansionary monetary policy shifts the supply curve
for loanable funds to the right. This increases the quantity of
loanable funds, and decreases interest rates. Lower interest
rates stimulates Aggregate Demand, in particular investment and
consumption, leading to higher levels of production and
employment. Contractionary monetary policy, on the other hand,
leads to higher interest rates, lower levels of Aggregate Demand,
and lower levels of production and employment.